Street Capitalist: Event Driven Value Investments

For those of you that don’t remember – when I started this blog back in 2007 Fairfax Financial (PINK:FRFHF/ TSE:FFH) was my largest holding. It was in September and I was nervous about the potential for the sub-prime issue to spread to the rest of the economy. Fairfax represented a really unique opportunity because I purchased shares not only at 1/2 book value but also received the benefits of their credit default swap portfolio which was positioned against major Wall Street financial institutions. In a way, I had an undervalued company which also gave me the ability to hedge against the worst financial crisis in recent history.

Today, Gregory Zuckerman has a wonderful article on Fairfax Financial in the Wall Street Journal:

As more investors worry about the possibility of deflation—or a sustained period of falling prices that could cripple stocks—Fairfax Financial Holdings Ltd. has spent nearly $200 million to buy derivative contracts wagering on a decline in the consumer-price index, an inflation indicator. The trade could lead to huge profits if deflation occurs.

Fairfax purchased some of the derivative investments in the first three months of the year, when few fretted about deflation and the cost of the contracts was cheap. It added more in the second quarter.

The derivatives now are catching the attention of some on Wall Street. They have gained more than 50% in value since Fairfax made its original purchases from a number of banks, generating paper profits of more than $100 million.

The Fairfax bet, which aims to protect $22 billion of Fairfax’s investment portfolio, comes as investors grapple with a particularly challenging environment, with the economy fragile and stock indexes struggling. Few investors are willing to make big wagers on deflation, despite its potential, with many skeptical any deflationary period would last long. The U.S. hasn’t experienced an extended bout of deflation since the Great Depression.

Firm Makes Bold Bet on Falling Prices (WSJ)

With The Greatest Trade Ever and The Big Short, investors went looking for cheap insurance against seemingly improbable events. Today though, that insurance isn’t so cheap. The massive waves of CDOs that were originated in the lead up to the financial crisis helped make a market filled with inexpensive CDSs. That isn’t true for today. To me, insurance is worthless if it is overpriced. Fairfax on the other hand is once again demonstrating their shrewdness. Spending only $174M to protect a $22B portfolio sounds like a good bet:

The Fairfax team believes U.S. households have only begun reducing borrowing and increasing savings, a trend it expects will lead to less spending, higher unemployment and deflation.

Fairfax paid $174 million in upfront fees to protect $22 billion of its investment portfolio against the possibility of deflation over the next decade. In exchange, Fairfax will receive a payment amounting to the drop in CPI below 2%—the level of inflation when Fairfax bought its contracts—multiplied by the $22 billion.

If deflation averages 2% annually over the next 10 years, Fairfax’s contracts would rise in value the equivalent of 4% of $22 billion, or $880 million, each year over the next decade, according to traders familiar with Fairfax’s trades.

In that scenario, if Fairfax holds on to its investments during the 10-year period, it would reap nearly $9 billion from its $174 million investment.

The company wouldn’t get anything for its bet if inflation turns out to be higher than 2% over the next 10 years.

Right now there is a debate about whether we will experience deflation or inflation. It is my thinking that we will follow deflation briefly before inflating our way out of it — moving us into a period of inflation. That seems contrary to Watsa’s bet. But the thing to keep in mind is that Prem Watsa, Fairfax’s CEO, needs to protect his investment portfolio.

Most people don’t realize this, but investment income is what keeps most P&C insurance companies afloat. From 1975 to 2009 there have only been 5 years where the P&C insurance industry generated positive underwriting income. Over the same period insurers had an underwriting deficit of $445B. To make matters worse, we’re in a period of abnormally low interest rates. Most insurers have the bulk of their investment portfolios in fixed income securities. That income is likely to face some downward pressure given today’s yield curve. Some insurers try to chase better yields by going into munis, but I’d be cautious. Some municipalities have rather high budget deficits making the chance of default not entirely unlikely. One might find good short candidates by going through the investment portfolios of different insurers and finding the ones with the worst positioned investment portfolios that are coupled with bad underwriting.

So when I see Prem betting $174M to protect a $22B portfolio against deflation, I don’t necessarily take that as Prem betting the house. $174 million is only about 0.8% of the portfolio. I see this as a way to make sure Fairfax’s investment portfolio, which is crucial to the company’s survival, is protected. As long as their counter parties in the trade (Citibank Canada and Deutsche Bank) survive. It’s entirely possible that the team at Hamblin-Watsa will seek out other derivatives to help them hedge against other adverse macro-economic scenarios. I think that as long as the trades are cheap and offer asymmetric returns, Fairfax will probably consider them.

What does this mean for individual investors like you and me? I think that if right now, you see Fairfax as being undervalued without the derivative trade working out – you might want to consider it for your portfolio. Worst case: you have a cheap insurance company run by one of the best capital allocators in the insurance business. Best case: you have a cheap insurance company that should help hedge your portfolio against deflation. Most individual investors are unable to purchase the kinds of hedges that Fairfax employs, so this is one way to work around that. I would not buy solely on the derivatives trade because we don’t know how long it will take for Fairfax to actually realize their gains (if they realize any at all).

I’ve been getting tons of e-mails and comments asking for a link to this lecture. Columbia seems to have gotten the message and has put it up on their site:

click to play: Video: Li Lu’s Spring 2010 Lecture

Last week, Fairfax Financial had their latest quarterly conference call. Fairfax is a holding company of different insurance operations helmed by Prem Watsa, a value investor who is sometimes called the Warren Buffett of the north. I first discovered Fairfax about 3 years ago. I learned of the company’s investing talents and saw that they looked undervalued while trading at a heavy discount to book value. Fairfax also held a portfolio of credit default swaps against major financial institutions which acted as a great hedge against the financial crisis.

Since then, I always look to their commentary to see how they think about today’s markets and their perspectives about risk in the future. Here’s what Watsa said about their hedge ratio:

Prem Watsa

Yes, I’m sorry. So, in response to the in equity markets in 2009, and early 2010, the economic uncertainty in the U.S. our equity hedge ratio to approximately 93% of our equity exposure. The effect of this increase by entering into Russell 2000 and total return swap contracts, average index level of 646.5. This was in addition to the S&P 500. Russell’s total return swap contracts we had done in September 2009 at an S&P 500. Now, I’ll give you some information on the line financials, Thank you.

Fairfax Financial Holdings Ltd. Q2 2010

By hedging 93% of their equity exposure, the folks at Fairfax must really be concerned about the possibility of another downturn. In a recent interview with Value Investor Insight, Watsa outlined some of his worries:

What environment are you positioned for today?

Prem Watsa: The two historical periods we believe are relevant are the U.S. in the Great Depression and the Japanese experience over the last twenty years. In Japan, nominal GDP remained flat for 20 years even though total debt as a percentage of GDP went from 50% to 200%. People will say it’s different this time and that that can’t happen in the U.S. Maybe, but I remember being in Tokyo in 1989 and people were saying the same thing. It won’t be that bad because we have high savings rates, or because the Keiretsu cross-shareholdings provide stability. Look how that turned out.

The economic story was similar in the U.S. in the Depression. After falling dramatically, nominal GNP came back up at the end of the 1930s to where it was in 1929, so there was no growth for the entire period. If not for the war, that would have lasted for a longer time.

So we don’t believe the financial crisis is over. After 20 years in which most developed countries saw leverage going to record levels, we think there are many, many years of deleveraging to go. Governments have tried to step in to mitigate the pain of that process, but as you see already in Europe, attention is turning to cutting spending and raising taxes. We expect after the mid-term elections to see much the same thing in the U.S. With a $1.5 trillion deficit and near-0% interest rates, there aren’t many bullets left.

Our conclusion is that the economy either stays relatively flat as it de-levers, or the economy slips and the resulting crisis of confidence contributes to a double-dip recession.

Are you at all concerned about inflation and rising interest rates?

Prem Watsa: Right now we’re more concerned about deflation, which would reduce Treasury rates even further. If we have a repeat of the U.S. in the 1930s or Japan over the past 20 years, long Treasuries could keep going down – or at least stay very low – for some time.

If we look at Fairfax’s equity portfolio, we can see that it is heavily weighted towards large cap high quality companies like Johnson and Johnson, Kraft, and Walmart. A number of investors have come out saying that large caps present a good value proposition right now – you can find some companies with a steady history of dividend increases and buybacks trading at historically high yields. If you’re worried about inflation, these companies are likely to provide better value than most fixed income investments.

Still, Fairfax has a substantial hedge on their equity portfolio. We know that Seth Klarman of the Baupost Group has also expressed concerns about how fast the market recovered after the crisis. So maybe there is a need to hedge portfolios. Now, smaller investors are precluded from buying the derivatives that Fairfax is using. The simplest choice would be to increase your cash allocation. Klarman has sometimes gone as high as 50% cash in recent year. If you want to get more complicated, you can use cheap insurance by way of out of the money options. With those you can profit immensely if the market declines far more than people expect, you are betting on an improbable event. These options are inexpensive because the event is so improbable to most. The flip side is that you need to continuously rollover that protection because options are targeted to a specific point in time. And it’s a negative carry trade, meaning that each time you are wrong and have to rollover, you lose a little money. The method you choose should fit your investing style. The options approach is definitely going to require more time and a means of offsetting the negative carry (or a willingness to accept it).

Two of my most popular posts on Street Capitalist have been about Li Lu. The first post was: Li Lu: Berkshire Hathaway CIO Candidate? I followed up with a second post, transcribing a lecture that Li gave to Columbia students in 2010 (Li Lu’s 2010 Lecture).

In the first post, I speculated as to whether Li might emerge as one of the Berkshire CIO candidates:

This past weekend was the Berkshire Hathaway (NYSE:BRK.A / BRK.B) annual shareholder meeting. At one point during the Q&A, a questioner asked Warren Buffett about the status of Berkshire’s CIO candidates. Charlie Munger remarked that one candidate who he is particular close with was up 200% in 2009 with 0 leverage. Some people think that the person Munger is referring to is Li Lu, a fund manager who turned Munger and Buffett onto BYD.

Li personally owns at least 2% of BYD, which rose 400% in 2009. I don’t know anything about his investments beyond that one position, but I know he is a huge believer in taking concentrated, high conviction positions. If that is the case here, BYD’s spectacular results must have contributed a lot to his returns for 2009 which may make a 200% for the year possible.

Li Lu: Berkshire Hathaway CIO Candidate? (Street Capitalist)

(From left to right: David Sokol of MidAmerican, Warren Buffett, Wang Chuan-Fu of BYD and Li Lu. Photo: David Yellen)

Today, Susan Pulliam has a great article in the WSJ which sheds light on Li Lu, speculating that he might be a CIO candidate. Pulliam managed to interview Charlie Munger and get some of his thoughts on Li Lu:

One of Mr. Li’s human-rights contacts was Jane Olson, the wife of Ronald Olson, a Berkshire director and early partner at a Los Angeles law firm Mr. Munger helped found. Mr. Li began spending time at the Olsons’ weekend home in Santa Barbara, Calif., and on Thanksgiving 2003 met Mr. Munger, whose home is nearby.

Mr. Munger says Mr. Li made an immediate impression. The two shared a “suspicion of reported earnings of finance companies,” Mr. Munger says. “We don’t like the bull—.”

Mr. Munger gave Mr. Li some of his family’s nest egg to invest to open a “value” fund betting on beaten-down stocks.

Two weeks later, Mr. Li says he met again with Mr. Munger to make certain he had heard right. In early 2004, Mr. Li opened a fund, putting in $4 million of his own money and raising an additional $50 million from other investors. Mr. Munger’s family put in $50 million, followed by another $38 million. Part of Mr. Li’s agreement with Mr. Munger was that the fund would be closed to new investors.

Chinese Investor Emerges as Possible Buffett Successor (WSJ)

The company that got people talking about Li Lu, as a potential successor to Buffett is BYD. Most people thought it was strange that Buffett would be investing in an automaker, based out of China of all places. But, I think that one of the allures for early investors in BYD was the fact that it is known as one of the best manufacturers of batteries in the world. Wang Chuan-Fu, BYD’s founder and CEO had to work hard to build his company with limited access to capital and technology. As a result, he fostered a corporate culture that thrived on thriftiness and ingenuity. That’s the kind of corporate culture Berkshire likes to invest in. Pulliam gives us details on Li Lu’s timing on BYD:

Mr. Li’s big hit began in 2002 when he first invested in BYD, then a fledgling Chinese battery company. Its founder came from humble beginnings and started the company in 1995 with $300,000 of borrowed money.

Mr. Li made an initial investment in BYD soon after its initial public offering on the Hong Kong stock exchange. (BYD trades in the U.S. on the Pink Sheets and was recently quoted at $6.90 a share.)

When he opened the fund, he loaded up again on BYD shares, eventually investing a significant share of the $150 million fund with Mr. Munger in BYD, which already was growing quickly and had bought a bankrupt Chinese automaker. “He bought a little early and more later when the stock fell, which is his nature,” Mr. Munger says.

In 2008, Mr. Munger persuaded Mr. Sokol to investigate BYD for Berkshire as well. Mr. Sokol went to China and when he returned, he and Mr. Munger convinced Mr. Buffett to load up on BYD. In September, Berkshire invested $230 million in BYD for a 10% stake in the company.

BYD’s business has been on fire. It now has close to one-third of the global market for lithium-ion batteries, used in cell phones. Its bigger plans involve the electric and hybrid-vehicle business.

One of the interesting aspects of having Li as a CIO candidate is that because of his international focus, particularly on China, he might be able to find the next great wave of global businesses. In his 2010 lecture, Li talks about analyzing BYD by looking at the early history of GM:

Q: I read that when you look at an industry, you look at the most miserable failures of that industry to see whether you will invest in it. Can you talk a bit about that?

Li Lu: It goes back to understanding the business. Once you have that understanding you can extend it to understanding an industry. A certain industry might have characteristics that make it different than others. In certain industries you might have better prospects than others. Find the best of the players in the industry and the worst players. And see how they perform over time. And if the worst players perform reasonably well relative to the great players — that tells you something about the characteristics about the industry. That is not always the case but it is often the case. Certain industries are better than others.

So if you can understand a business inside out you can then eventually extend that to understanding an industry. If you can get that insight, it is enormously beneficial. If you can then concentrate that on a business with superior economics in an industry with superior economics with good management and you get them at the right price — the chances are that you can stay for a very long time.

Q: Did you have any specific example?

Li Lu: I have studied many over the years. As I have said, don’t copy other people’s insights because it doesn’t work. Automobiles are amazing. If you look at the early days it started with several players and concentrated with just a few players that became enormously profitable. Then they became miserable. You then see how the life cycle turns with new automakers in China and India. Everything has a reason. If you want a good idea — look at General Motors from the early days, look every 5 years and see how the performance metrics change. The Graham and Dodd Center should collect all the data and perform some kind of commentary on it…

If you have that data, the amount of insight that would yield would be astonishing. So instead of just accepting the conventional wisdom that the auto business is bad — that is just not true. Or if you say well those guys just unbelievable money machines — that is not true either. So if you can really examine those statistics and understand it that will give you an advantage for analyzing new situations like in China and India. That is really what turns me on. Understanding this gives you a tremendous leg up.

This to me, is one of the advantages in having a CIO candidate that is focused on international opportunities. As nations like China and India develop, they’re bound to naturally mimic the development of Western countries in certain ways. They might actually start to have great businesses that arise out of necessity, “repeating” what’s gone on in America. This is particularly true in areas such as logistics and transportation which become more and more essential as countries develop. In a few years there might be domestic versions of FedEx or Sysco in China and India — if there aren’t already.

Just how much did Li and Buffett make off of BYD?

BYD is a big roll of the dice for Mr. Li. He is an informal adviser to the company and owns about 2.5% of the company.

Mr. Li’s fund’s $40 million investment in BYD is now worth about $400 million. Berkshire’s $230 million investment in 2008 now is worth about $1.5 billion. Messrs. Buffett, Munger, Sokol, Li and Microsoft founder and Berkshire Director Bill Gates plan to visit China and BYD in September.

Pulliam ends the article with Li’s analogy between investing and soccer:

Mr. Li declined to name his fund’s other holdings. Despite this year’s losses, the $600 million fund is up 338% since its late 2004 launch, an annualized return of around 30%, compared to less than 1% for the S&P 500 index.

Mr. Li told investors he took a lesson from watching the World Cup, comparing his investment style to soccer. “You may very well work extremely hard and seldom score,” he says. “But occasionally—very occasionally—you get one or two great chances and you make decisive strikes that really matter.”

Li’s approach to investing is really similar to Buffett’s own advice to wait for the market to give you fat pitches. I think most investors mess up by lacking that kind of patience.

In environments where there aren’t a whole lot of bargains, some value investors will begin to relax their standards in order to participate more in the market’s rallies. This almost always ends in disaster. If you are not disciplined with value investing you can get yourself into tight spots. It’s a strategy that often encourages taking high conviction, concentrated approaches to investing. An investor without discipline might end up with a portfolio of only 8 stocks at really expensive valuations. When the bubble bursts, their portfolio will take a massive hit and usually perform worse than the market indices because of that level concentration.

In his 2010 lecture, Li emphasized the need to know what you don’t know when investing. That might sound a bit like a riddle, but it’s really about acknowledging that you can’t know everything and there are going to be risks that you cannot anticipate. If you accept that idea, you’re always going to be looking for businesses with strong competitive advantages and seek to buy at a discount to intrinsic value. That way you have some protection against those unknown risks. With that intellectual framework and a willingness to employ rigorous analysis, you should be able to identify good investments and profit immensely.

Joanna Pachner at Business Without Borders has a fantastic article profiling Bruce Flatt and his company Brookfield Asset Management:

As a rule, the CEO of Brookfield Asset Management is studiously non-controversial. He rarely appears in public and has little to say to the media. Put-downs? Bravado? “We don’t brag,” he says earnestly. “It always bites you afterwards.”

Instead, Flatt seems to go out of his way to paint Brookfield as boring. “We own 129 office buildings. Some are a little taller, some are a bit shorter,” he says laconically. The strategy? “We’re in the business of buying assets of great quality at less than replacement cost.” The company’s remarkably consistent objective over the years simply has been to earn a 12% to 15% compound annual return per share. “We have no goal to be large or significant,” says Flatt. “If [reaching our objective] meant we should shrink in size, we’d do that.” Even Brookfield’s logo is understated, and its 2009 annual report looks like something thrown together at Kinko’s. Move along, everyone, nothing to see here.

The reality is that this slender 45-year-old executive runs a conglomerate that manages $108-billion worth of real estate, utilities and infrastructure across the planet. In the eight years Flatt has been in charge, Brookfield has emerged as the world’s biggest owner of prime office space—including some of the most prestigious towers on the Manhattan skyline—and its 165 power plants constitute one of the largest hydroelectric portfolios. But what has really impressed observers is how Brookfield weathered the crushing downturn that crippled many of its rivals. Over two years, as its stock plunged by two-thirds along with the markets, the company didn’t panic or go into hype mode. Instead, it quietly added to an already thick cushion of capital. And waited.

…The business landscape is littered with companies that gambled with cheap money and got caught with their shares down and their loans called. Brookfield, meanwhile, has amassed a nearly $10-billion war chest of its own and institutional investors’ cash and has gone hunting. After devouring an Australian port and railway giant and a few real estate portfolios, it’s now tracking perhaps its most succulent prey: General Growth Properties, the second-largest mall operator in the U.S., which adopted the spendthrift ways of its customers, stockpiled a glittering array of trophy properties on credit, and when the markets seized, toppled into bankruptcy. Enter Brookfield, offering up its capital and restructuring expertise in exchange for control of the company.

Whether or not Brookfield secures the deal—the outcome may not be known until this fall —it’s an important chapter for the company, says a close long-time observer who requested anonymity. “This could be a huge new platform for them. Or it could be a huge profit.” Some see it as an unusually risky play for careful Brookfield. But they don’t appreciate its predatory ways.

A Perfect Predator (Business Without Borders)

Be sure to read the entire article. It’s wonderful and details how Flatt has reoriented Brookfield since taking over as CEO.

Brookfield is an interesting business in that much of its revenue stream in that its properties throw off a substantial amount of free cash flow (about $1.5B annually). Some of their properties are more economic sensitive than others – particularly the office buildings and potentially the malls that they would acquire from General Growth Properties. But that would be offset by their infrastructure investments.

For investors hoping to find a savvy team of deal makers who will invest opportunistically in real estate, Brookfield is a good place to start. There aren’t a whole lot of value oriented real estate groups like Brookfield. A lot of the players simply try to buy and sell into bubbles.

Pachner compares Flatt and Brookfield’s approach to investing as similar to the entrepreneurs cited in Michel Villette and Catherine Vuillermot book From Predators to Icons: Exposing the Myth of the Business Hero. This is a good comparison. For the most part, Flatt has been able to steer Brookfield into investing conservatively during bubbles which enables them to build up cash hordes and purchase distressed properties at a discount to their margin of safety when there are few other real competitors.

The most difficult thing about analyzing Brookfield is probably their size. While it helps when they are getting involved in special situations and deals, but it creates difficulty for an analyst attempting to value the company with precision. I think that if you use the intrinsic value estimates that Brookfield provides, along with that average free cash flow figure of $1.5B. You can then get an approximation of what Brookfield is really worth and compare it to its trading price. Ideally you want to obtain a margin of safety and then get the kicker of their investing prowess which should compound intrinsic value.

Many of you enjoyed my previous transcript of a talk Li Lu gave at Columbia University. Thanks to Joe Koster, you can now view a more recent lecture he gave to Bruce Greenwald’s value investing class in April of 2010.

Based on Berkshire’s investment in BYD, the fact that Lu manages Charlie Munger’s money, and that even Buffett would give money to Lu if he ever retired (according to Greenwald) makes me think Li Lu is an investor worth watching.

With that in mind, I believe it is insightful to study whatever you can find about him and his approach. I think this lecture from 2010 is great. The recording has some audio issues making it difficult to hear and I thought that some of you might enjoy reading notes from the talk. This is not a true transcript, but an approximation of what was said. I think it comes pretty close, having listened to the lecture a few times. I think you will find it helpful and Lu’s talk rewarding.

Bruce Greenwald: Warren Buffett says that when he retires, there are three people he would like to manage his money. First is Seth Klarman of the Baupost Group, who you will hear from later in the course. Next is Greg Alexander of the Sequoia Fund. Third is Li Lu. He happens to manage all of Charlie Munger’s money. I have a small investment with him and in four years it is up 400%.

[Applause]

Li Lu: Columbia is where my whole life in America started. I could barely speak the language. In Columbia it was where I had a new life. It was really in the Value Investing class where I got my career start. I was really worried about my student loan debt at the time and a friend told me about this class and said I need to see a lecture from Warren Buffett.

What I heard that night changed my life. He said three things:

1. A stock is not a piece of paper, it is a piece of ownership in a company.

2. You need a margin of safety so if you are wrong you don’t lose much.

3. In the market, most people are in it for the short term. It allows you a framework for dealing with the day to day volatility.

Those were three powerful concepts. I had never viewed the stock market like that. I viewed it negatively as a place made up of manipulators who were lining their own pockets. I embarked on an intensive two year study learning everything about Buffett.

Two years after that I bought my first stock. After I graduated I worked at an investment bank for a year and realized it was a mistake. I tried to start a fund but I didn’t have a track record. The first year I managed money I lost 19%.

Being a value investor means you look at the downside before looking at the upside. Before becoming an investor you need to look at how you can fail at this game. There are all sorts of ways you can fail. You need to examine who you are and see if you could be good at it. If you could ever find something you can do well that you really like — that will be your best investment. You will do better than competitors. If you can do it with intrinsic passion, that really over time will add enormous value to you.

Back to the game of investing. This concept of margin of safety is an essential concept to be a good investor. The future is unpredictable, you will always be dealt surprises, some positive most negative. You need to build in a level of safety so that whatever happens, you will not get crushed. If you can really successfully know what you are getting into, you can pretty much navigate. Most people are troubled by what they don’t know. The world is divided by those who know and those who don’t know. If you really know — you will not pull triggers like Wall St. traders. If you are truly intellectually honest, you would not do anything.

This class teaches you to know what you are getting into, especially accepting what things you don’t know. The game of investment is really continuous learning. Everything affects an investment, it constantly changes. You are not investing in the past but the accumulative cash flow of the future. You have to want to find a certain set up where you can know something that most people don’t know. There are plenty of things I don’t know but they don’t factor into the purchase because I am using a huge margin of safety. Buying a dollar at 50 cents. So if things turn against you, you will be okay. That is not easy. This business is brutally competitive. It is so impossible to know everything and know exactly what is going to happen to a business from now till the end that you really have to accept that what you don’t know.

Finding an edge really only comes from a right frame of mind and years of continuous study. But when you find those insights along the road of study, you need to have the guts and courage to back up the truck and ignore the opinions of everyone else. To be a better investor, you have to stand on your own. You just can’t copy other people’s insights. Sooner or later, the position turns against you. If you don’t have any insights into the business, when it goes from $100 to $50 you aren’t going to know if it will back to $100 or $200.

So this is really difficult, but on the other hand, the rewards are huge. Warren says that if you only come up with 10 good investments in your 40 year career, you will be extraordinarily rich. That’s really what it is. This shows how different value investing is than any other subject.

So how do you really understand and gain that great insight? Pick one business. Any business. And truly understand it. I tell my interns to work through this exercise – imagine a distant relative passes away and you find out that you have inherited 100% of a business they owned. What are you going to do about it? That is the mentality to take when looking at any business. I strongly encourage you to start and understand 1 business, inside out. That is better than any training possible. It does not have to be a great business, it could be any business. You need to be able to get a feel for how you would do as a 100% owner. If you can do that, you will have a tremendous leg up against the competition. Most people don’t take that first concept correctly and it is quite sad. People view it as a piece of paper and just trade because it is easy to trade. But if it was a business you inherited, you would not be trading. You would really seek out knowledge on how it should be run, how it works. If you start with that, you will eventually know how much that business is worth.

When I started in the business in 1997, it was in the middle of the Asian Financial Crisis. A few years later there was the Internet bubble. A couple years ago was the Great Crash of 2007 – 2008. They are billed as once in a century disasters but happen every few years. Every time it goes against you, your net worth or value of your investments might go down 50%. This is really where that insight and temperament comes in. In a sense, you have to have a certain confidence in your own judgement and not be swayed by other people’s views. It is not easy. But that is life. It is just a given. It happens to everyone. Berkshire had at least three times when the stock went down 50%. It happened to Carnegie too. It happened to Rockefeller. It happens to everyone. If you really made a mistake, it would not stop at 50% but go to 0.

This happens to even mighty companies. Look at the top 50 companies in America every 10 years. By the time 20-40 years go by, 2/3rds of them will be gone. By the time it goes to 100 years, there might be only a couple left. It’s just the way it is. Look at what happened to the once mighty General Motors. So thats why I’m saying is, investing is a continuous learning process because your investments are constantly changing

So for those of you that have curiosity and the temperament, this game couldn’t be better. Capitalism rewards people who are talented at capital allocator. So if you have the aptitude and temperament, it is the great game. If you don’t have that then I urge you not to go and become a nuisance. That is really what Wall Street did, they don’t really create anything they just move money around. Letting the financial industry get too big is bad for the economy, it is just as bad as getting addicted to casinos, drugs, and alcohol. None of them are really useful, they just transfer wealth. That is what I think happened on Wall Street over the last several decades. So avoid being harmful.

With that I am open to questions.

Q: Mohnish Pabrai recently spoke about his reluctance about investing in China due to the multiple accounting books / the possibility of fraud. How do you deal with this given your own investments in China?

Li Lu: Well, you know I think he is right. Every thing has an exception though. Just because a next door neighbor is a fraud doesn’t mean you are. That is one question to ask — whether you can trust the accounting and people running the business. That can have a huge impact on the business. I suggest you spend a lot of time looking at these factors, especially if you are investing for the long haul.

Q: Why did you decide to go into venture capital? How is that different than your other investing?

Li Lu: I always had this bent that I want to build a real business. I started a venture and it was really a lot of fun. Overall, it is a tougher game than simply investing in securities because you have to evolve to the day to day changes in operations and it is just not as easy to build great businesses. Every generation has a handful of great businesses that come from no where and come to dominate their fields. It is much more rewarding as an investor to pick those. Also, you are more likely to find managers much more capable than yourself. Overall, I learned a lot. I learned a lot in how businesses succeed and how businesses fail. It really was a lot of fun. I probably carried it too far — I eventually ran one of the businesses and it was of course a mistake.

Q: I read that when you look at an industry, you look at the most miserable failures of that industry to see whether you will invest in it. Can you talk a bit about that?

Li Lu: It goes back to understanding the business. Once you have that understanding you can extend it to understanding an industry. A certain industry might have characteristics that make it different than others. In certain industries you might have better prospects than others. Find the best of the players in the industry and the worst players. And see how they perform over time. And if the worst players perform reasonably well relative to the great players — that tells you something about the characteristics about the industry. That is not always the case but it is often the case. Certain industries are better than others.

So if you can understand a business inside out you can then eventually extend that to understanding an industry. If you can get that insight, it is enormously beneficial. If you can then concentrate that on a business with superior economics in an industry with superior economics with good management and you get them at the right price — the chances are that you can stay for a very long time.

Q: Did you have any specific example?

Li Lu: I have studied many over the years. As I have said, don’t copy other people’s insights because it doesn’t work. Automobiles are amazing. If you look at the early days it started with several players and concentrated with just a few players that became enormously profitable. Then they became miserable. You then see how the life cycle turns with new automakers in China and India. Everything has a reason. If you want a good idea — look at General Motors from the early days, look every 5 years and see how the performance metrics change. The Graham and Dodd Center should collect all the data and perform some kind of commentary on it.

Bruce Greenwald: Do you want me to give you the answer to that? In the 1960s, their return on capital was 46%. In the 1970s their return on capital was 28%. In the 1980s it was 9% in the 1990s it was 6%. You want to guess how negative it is now?

Li Lu: So that is really fascinating. If you have that data, the amount of insight that would yield would be astonishing. So instead of just accepting the conventional wisdom that the auto business is bad — that is just not true. Or if you say well those guys just unbelievable money machines — that is not true either. So if you can really examine those statistics and understand it that will give you an advantage for analyzing new situations like in China and India. That is really what turns me on. Understanding this gives you a tremendous leg up.

Q: I wanted to ask you about BYD. I heard that you thought it was important for them to introduce a model to the US and wanted to know why you thought that.

Li Lu: That might be a better question to ask the BYD chairman than myself. Well, If you are just talking about electric vehicles, you know the key — the heart and soul of the electric vehicle age the heart is the battery. There is the battery, electric motor, and the electric control control panel. The electric motor has been there for 100 years, control system is software that can be improved over time.

The battery is really where you get the biggest appreciation and is what determines the value of the electric vehicle. 100 years before the Model-T was introduced, the competition between electric vehicles and gasoline was not nearly as optimistic. Up and till then, 1/3rd of cars being produced were electric. It wasn’t until Rockefeller got oil extracted easily enough that it worked. Henry Ford was able to make the internal combustion work even though it wasted 85% of the energy. He was able to build the engine and produce automobiles that were cheap enough for people to buy and it took off. That is where you find the real winners.

Now, years later, we know that the way that oil is burned contributes to global warming. If it continues, the planet might still be here but all the human beings might not. Human beings have only been on the planet for a tiny bit of the earth’s history. So there are all sorts of good reasons for electric cars. Battery development has advanced so much that it is now comparable to the price and performance of traditional cars. So now with the help of companies like BYD, the balance is about to tilt towards where performance and price are getting to the level that makes them a desirable alternative. It will be desirable everywhere. Eventually, if you have a car that does all that, it will be sold everywhere.

Q: What about BYD versus others in the industry?

Li Lu: The market will determine that.

Q: Yeah – but why BYD versus others?

Li Lu: Well because we also studied all those other guys. We will see when the winner emerges whether we are right or wrong.

Q: Right – but what did you look at to reach that view?

Li Lu: There are a lot of people who have worked over 100 years making great cars. The technology for building a traditional car has been refined enough to where it can be learned in a short period. The place we are still seeing a curve of continuous rapid improvement is with the batteries for cars. Whoever is leading the charge will have a major advantage. There is really only one company that is a leader in battery manufacturing and automobile manufacturing. There is only one company. To put this together you need a Ford to put that together. So far those two elements need to be put together. It is not an easy process.

Q: So you went to BYD in 2005 and then you brought Berkshire as well. I saw that you sold a small amount of your BYD position at the end of last year. Was it just rebalancing? Can I just wanted to get your thoughts on that.

Li Lu: Actually I started my BYD position in 2002. I sold a small amount of shares because an investor of mine had an emergency redemption.

Q: We read your profile online. I had a question – do you have any problems when trying to invest in China?

Li Lu: Yeah I do have some difficulty. I did not really see a factory plant at BYD until the end of 2008. I really did not have a better understanding till then. That really causes you to question what it is before you make an investment. With investing, you have to work with imperfect information because you are buying a piece of the future. I did not really get a chance to get more information because the problem in Asia till much later but it did not stop me from making my investment decision. So there is a point, where if you have enough margin of safety– that is why I kept coming back to the elementary concept of margin of safety– you can allow much more uncertainty and unknowns. So the answer of the question is does that stop you from making the investment? No.

Q: So I did some research on lithium ion batteries, and I saw that BYD has a manufacturing advantage with consumer batteries. But I saw that automobile batteries are much more complex. I did not think that the idea of a good consumer battery manufacturer + an automobile maker made much sense. So when Buffett looked at the stock maybe it was a better deal but today it is this dream of vehicles that is really priced in. It does not feel like a good value investor stock. So why would you own it today?

Li Lu: Well that is interesting. One of the most fascinating things about being an investor is that surprises are part of the game. When you get into situations like BYD, you see lots of good surprises. Chuanfu and his team have this fabulous culture, everything people thought they knew turned out to be a few years late. He got into battery manufacturing in that particular way because he really had no other option. He had no money, he only had $300,000 in venture capital funding before IPO and that was it. He raised money in an IPO and Buffett gave him $200M, now they have 160,000 employees. $6-7B in revenues, $500M in net profit. It is amazing. So he has this ability to adapt in a competitive environment. He has demonstrated that ability again again and again. The way he does automation is far cheaper than anyone else and more reliable. He continues to surprise me with his ingenuity, to figure out ways to do something better than everyone else. What he is currently doing is very different than what everyone else has done. At the end of the day, you might look at what he has done.

So how do you look at it as an investor with imperfect information? Well I suggest you look at what he has accomplished. 8 years ago I had no idea they would go into the automobile or laptop or cellphone battery business. So that demonstrates how he is. This investment is not easy to understand because it is changing so fast, at such a large scale. An almost unheard of speed. Their manufacturing capabilities will double soon. This year they will hire 10,000 college graduates, 8 or 9 thousand engineers. The scale is almost unparalleled. So this is why the study of history, of all the great corporations will give you a good insight in seeing what will happen with BYD. I suggested that we start with GM and analyze its performance every 5 years for 100 years to understand at least one aspect of BYD’s business.

Q: One investor came in and said talking to management is a waste of time. They will say what you want them to say. Obviously it sounds like you don’t agree with that. What do you think? Will you pay a premium for a business with a moat?

Li Lu: There is no general rule. The key in investing is to know what you know and know what you don’t know. You can know about management teams without meeting with them. Every situation is slightly different. So I come back to the point that if you know enough on other things that there is enough margin of safety. Even if you meet with management, you may not learn something. Obviously, actions speak louder. You want to see what they have done. Everything being equal, the more you know about management, the more honest and upfront they are, the more motive they have, the better the situation is and the deeper the discount. You have to analyze it all. The key to analyzing it is you have to ask: do I really know what I think I know, do I really know what I don’t know? If you can’t answer that question, chances are you are gambling.

Q: What kind of preparation do you do before meeting a management team?

Li Lu: I don’t really have a set method. Because I usually am just curious about the business and don’t know a lot. So you are prepared and not prepared. If you are really curious, you want to learn more and study it more. When working at a hedge fund or mutual fund, you are expected to learn a business in one week. You can’t truly understand everything about a business in one week. It took me 10 years and I am still learning new things about BYD. It is a continuous learning process. You could spend a lifetime studying a business or industry, but in a few seconds I can tell you whether or not I like it. You want to build knowledge by continually learning. There is not set preparation.

Q: Recently, Jim Chanos gave us his thesis on the China Syndrome with there possibly being a bubble.

Li Lu: Well, it is too big of a question for me. I don’t know

Q: 20 years ago you said you challenged conventional wisdom in China. Out of curiosity, in terms of value investing what do you challenge in the conventional wisdom?

Li Lu: Well, the fundamental philosophy of value investing is very sound. Its basically the three things:

1. A stock is not a piece of paper, it is a piece of ownership in a company.

2. You need a margin of safety so if you are wrong you don’t lose much.

3. In the market, most people are in it for the short term. It allows you a framework for dealing with the day to day volatility.

That is really an intelligent approach. So therefor any intelligent investing is really value investing. There is a certain level of intellectual honesty. If you have all that insight going into analyzing businesses I don’t have any arguments with it.

Q: What is your point of view on long / short positions in value investing?

Li Lu: The most profitable kind of investing is long term investing. You want to allow the time that it might take because you don’t know when the market will catch on. If you can find a business with good management with good industry fundamentals blowing it forward, you have a good opportunity and you can save money on taxes.

A short cannot be a fundamentally long term position. In the long game, the upside is unlimited. Your downside is 100%. In shorting it is opposite. Shorting is also essentially borrowing, so you need money and time on your side. If time is not on your side, you can be right but lose all your money. The best kind of short usually has some kind of fraud. In those situations, management is determined to keep the fraud. Look at Bernie Madoff, 20 years time. You cannot afford to borrow money for 20 years. So shorting is a short term game. When those positions go against you, there is huge leverage that can utterly crush you.

In theory, long / short is okay, but if you are trading all the time you need to be in tune with all the things moving the market. None of them might be fundamental to the actual business. So you spend all your time chasing noise than studying a long term situation. If you cannot concentrate on things in the long term, and spend all your time thinking about the short term, you will not be able to develop the kinds of insights necessary to identify great investments.

From time to time, you will lose some money on paper. But it is just part of the game. This is why I closed long / short. You know I went through three bubbles. The Asian Financial Crisis, the Internet Bubble, and this most recent financial crisis. The biggest mistake I made is not being able to pick up undervalued companies where I had a unique insight but was tied up with this whole long / short thing. The money I left on the table is still adding up. I am still paying for those mistakes.

Q: In a bull market environment, how do you re-evaluate your thesis?

Li Lu: I don’t ever want to profit from a bubble. Soros does that, that is just not my game. I don’t profess any ability to understand how long a crowd will buy into a bubble. I invest in things that appear to be compelling values that continues. So that is why this game is a continuous learning process – because everything affecting the investment is constantly changing. Including the price. Including the prospects and elements of business success. You really do want to never stop learning. This game looks to be easy but it is not easy.

Q: Given your focus on international investments, how do you think about diversifying your investments regionally?

Li Lu: First of all, I did not really specialize in international investments. I started off doing most of my investments in the US and Canada. In recent years, I just find better bargains outside of it. One of the great things about being an investor is you can look anywhere and find great pockets of opportunities. You cannot do that as a venture capitalist as I experienced myself. So you can look anywhere for opportunities. I do not take a regional approach to diversification. I have views towards certain countries and currencies, but it is not the driving force for a potential investment. If you have your fundamental things right, if you happen to have macro economic factors behind you, you can run a great wave.

Q: How is your investment style different today than when you started the fund?

Li Lu: A lot of things have changed. One bonus about this profession is you get better over time. Most professions, as you get older, you get out of the game. Take the example of competitive sports. If you are a figure skater or gymnast, after your teenage years you are out of the game. With investing, if you are doing it the right way, you get better over time. Your knowledge accumulates exponentially. When I look back at everything I have done, I would have done it all slightly differently, but that is because I am better at it today. So if you approach it in a fundamentally sound way, as you mature, you become better and better. That process and progression is like compounding money. In fact, you can compound knowledge faster than money. If you truly love this game, I would suggest that you don’t take short cuts. It might take longer but it is more rewarding.

Q: What is the difference between being a top political criminal in China versus a hedge fund manager today (referring to the ire directed at Wall Street)?

Li Lu: I don’t consider myself a criminal. I don’t think China considers me a criminal. What I think we are doing today with our investment in BYD in China is really helping China march towards a modern era of prosperity. BYD is providing a solution to both China and the US, to migrate from the past to a way that gets us out of the unsustainable carbon age that we live in. Global warming is a vital concern to every human being, so China is providing a great contribution to everybody with BYD. America has had a great history of invention and here is a great company in China that is about to make a major contribution to human civilization with cheap electric vehicles and solar power.

Ultimately we will have to get our energy from the sun. Most of the energy, even fossil fuels (plants that die and then go into the ground), all originally come from the sun. So if you can figure out a way to take energy from the sun and power vehicles, while using batteries to store it, inexpensively — will really make renewable energy power everything. The combination of those things holds the key to the future of industrial civilization that we are about to embark on. We didn’t set out with BYD with this in mind, it just happened that way. With great companies, it only looks logical in retrospect. Think about how Bill Gates started Microsoft. I don’t think he knew up front that he would take the entire market — at that time it did not exist. It is the same way with our investment in BYD. Ultimately, I think finding an inexpensive way to store energy that we harness from the sun will be a huge contribution for both China and the US, but more broadly our entire civilization.

I just caught a CNBC’s Situation Room where they had David Barse of Third Avenue on BP (NYSE:BP). Third Avenue is a legendary value investment fund that used to be run by Martin Whitman. They take a really disciplined, Benjamin Graham-like approach to value investing and often will go into distressed debt situations and workouts.

The folks over at CNBC asked him some questions about the current BP situation and I thought it would be worth sharing. This is not a transcript but just notes that I took from a recording.

I was actually looking forward to this because I believe it is the first time I’ve heard of a value investor talking about BP.

Now that there is a $20B escrow fund established by BP, is it time to look for value?

Barse: There is another level of certainty that value investors, or contrarians need.
Still too much uncertainty, contingent liabilities that are unknown, timeframes of repayment that are unknown. That can affect your return on investment. Not really safe and cheap, which is what Third Avenue does.

Some value investors have reported that they are taking a dip into BP. Do you think they are just taking a speculative trade here?

Barse: Probably. Because there is still great uncertainty. It is a tough call.

Any analogous situation here from your long investment career?

Barse: Let’s look at Texaco. A company that was solvent that used the bankruptcy process to stem an uncertain liability, stabilize the market, and reorganize the company in a rational way. That might be an avenue for BP.

When you look at the situation, you don’t know the overall. With Texaco you had the whole Pennzoil case. Do you think there would be any benefit for equity investors for filing?

Barse: Our laws are written to protect the debtor. In this case, they are the debtor. It is certainly something that behooves them to look at and analyze. Is it proper for the President to tell them how much to put in an escrow account? Right now it is a company owned by the shareholders.

How will they fund the $20B? Do you think they will do a debt offering?

Barse: Okay so, this is a company that has access to capital markets, but certainly the cost for that access is going to be higher than it was prior to the crisis happening. That is a factor they will work into that decision. This would be a debt offering that would get an oversubscription because it is a great company. It is a company that is certainly a survivor. Long term, this will cost less than the market cap.

So you think it will cost less than $100B?

Barse: Based on what we know, it seems like it will be less than that. But it is an uncertainty and that is why we are not investing in the equity.

Could some bond managers that are unhindered by requirements dealing with ratings look at BP?

Barse: In the market environment of last year when credit was wider in terms of spreads, we launched a focused credit fund to invest in situations like this. We call these special situations and certainly the yield for a BP… We would take a much closer look at a debt offering.

Barse ended with a recommendation that people should look at Hong Kong property stocks.

As you can see, one of the big topics of the discussion was on the newly announced $20 billion dollar escrow account that BP agreed to establish. The New York Times has details on it:

The White House and BP tentatively agreed on Wednesday that the oil giant would create a $20 billion fund to pay claims for the worst oil spill in American history. The fund will be independently run by Kenneth Feinberg, the mediator who oversaw the 9/11 victims compensation fund, according to two people familiar with the deliberations.

The agreement was not final and was still being negotiated when President Obama and his top advisers met Wednesday morning with BP’s top executives and lawyers. The preliminary terms would give BP several years to deposit the full amount into the fund so it could better manage cash flow, maintain its financial viability and not scare off investors.

The talks have been complicated by the fact that BP’s ultimate liabilities for the cleanup and lost business are unknowable since the two-month-old leak of its well in the Gulf of Mexico could be spewing oil for months more. To date, BP has spent more than $1 billion on containment, cleanup and claims from the Coast Guard, fishermen, oil workers and other businesses from Louisiana to Florida.

BP Agrees to Set Aside About $20 Billion for Spill Claims (NYTimes)

Overall, I think his approach is a good example of real value investing. A lot of pretenders are out there, looking at the stock, and they do these really simple (or poor) calculations. They will look at the operating cash flows and not the capital expenditures. Or they will assume a payout of $X billion dollars over 20 years when maybe the requirement will be payments in 5 years. Maybe as a result of this spill, BP will have a much more difficult time getting contracts to do deepwater exploration and as a result, their franchise will be permanently impacted. With all the uncertainties it is a really difficult call when you are trying to determine BP’s intrinsic value.

I think that Barse’s idea of looking at the debt is a good one. The recent downgrades by Fitch and others will preclude certain bond managers from buying their debt. Plus there will be a social stigma attached that might lead environmentalist groups to urge pension funds and endowments from BP related investments. These situations could make the debt offer an attractive yield to agile, unhindered investors.

Edit: Whitney Tilson is another value investor who has actually been bullish on BP for over a week. Still, I think Barse’s insights — especially from his bankruptcy background add a lot of value since it is a scenario that has been talked about.

Today, Charles Stein over at Bloomberg has an excellent article detailing what happened to Seth Klarman’s Baupost Group during the financial crisis:

Seth Klarman almost doubled his hedge fund’s assets to $22 billion in the past two years as the industry shrank by sticking with the off-the-beaten-path investments he’s pursued since starting out in 1983…

While Klarman didn’t post the gains that made Paulson famous, he was able to raise almost $4 billion in 2008 when firms including D.B. Zwirn & Co. and Peloton Partners LLP liquidated funds. Baupost was the ninth-largest hedge-fund firm as of Jan. 1, according to AR magazine, Pensions & Investments magazine and data compiled by Bloomberg. He oversees more money than better-known managers such as Ken Griffin and Steven Cohen.

Klarman Tops Griffin as Hedge-Fund Investors Hunt for `Margin of Safety’ (Bloomberg)

I really think Baupost’s performance during the financial crisis was exemplary of value investing at its best — going into the crisis, many fund managers were overly concentrated in long positions. Even the famed long/short funds, which were supposed to use shorting to hedge against market downturns were simply not short enough to make a difference.

Most long-only value funds ran into the same issue. This stems mainly from an unwillingness to take large cash positions when the market gets frothy. That kind of value investing cuts both ways, taking a few concentrated positions will usually allow you to outperform major indices, but it also means that during a downturn your portfolio may get hit with higher than average volatility. As a result, some value funds would actually underperform the S&P 500′s already dreadful performance.

Most people like to knock Baupost’s performance in the 90′s, for not outperforming the S&P but I think that misses the point. What Klarman and his team have put together at Baupost is a fund that can achieve great absolute returns. For some entrepreneurial investors seeking massive John Paulson-like returns, this might not mean much. For college endowments though, having the benefit of limited losses, or actually appreciating in a down year must be a tremendous asset and shows the kind of niche that Baupost can serve.

The other thing that stands out about Baupost is their willingness to travel across all asset classes in search of returns:

A value investor who looks for securities he considers underpriced, Klarman, 53, said he’s best at “complicated” situations where fewer investors compete for assets. Over the years, Baupost has invested in Parisian office buildings, Russian oil companies and real estate that the U.S. government disposed of following the savings and loan crisis of the early 1990s, said Thomas Russo, a partner in the Lancaster, Pennsylvania-based investment firm of Gardner Russo and Gardner…

“He specializes in illiquid, complex assets,” said Russo, who has known Klarman since 1984.

Baupost gained an average of 17 percent annually in the 10 years ended in December, a period in which the Standard & Poor’s 500 Index fell 1 percent a year. The hedge fund has returned 19 percent a year since it was started, even as it held more than 40 percent of its assets in cash at times.

More recently:

Among the money-making bonds Baupost purchased, according to an October 2008 shareholder letter, was debt issued by Washington Mutual Inc., whose bank unit failed in 2008 and was bought by New York-based JPMorgan Chase & Co. Baupost also acquired bonds of CIT Group Inc., a New York-based lender that emerged from bankruptcy in 2009. The fund was part of a group of creditors that made a $3 billion loan to CIT in July 2009.

Klarman, in a May 18 talk to financial advisers in Boston, cited another Baupost purchase during the crisis to illustrate the way he thinks about investing. In a series of “what if” exercises, the firm calculated how much bonds of Ford Motor Credit Co. would be worth under different scenarios, including an economic depression in which loan defaults rose eightfold. The conclusion: the bonds, then selling for about 40 cents on a dollar, would still be worth 60 cents.

Stein goes on to outline some of Klarman’s more macro views. His fund is bearish and worried about inflation. Baupost’s US equities weigh in at only $1.7B versus their $22B in AUM, or a about only 7.8%. In addition, like many others, Klarman is apparently a big fan of Jeremy Grantham’s research at GMO:

Klarman’s views on the U.S. stock market echo those of Jeremy Grantham, chief investment strategist at Boston-based Grantham Mayo Van Otterloo & Co., who recommended investors buy stocks in March 2009 after more than a decade of saying they were overvalued. Grantham’s latest forecast, posted on the firm’s website, predicted U.S. large cap stocks would return 0.3 percent a year, adjusted for inflation, over the next seven years.

Klarman called Grantham “a very smart person” whose forecasts he watches carefully. In an e-mail, Grantham called Klarman “just about the smartest guy around.”

How does Baupost hedge against such possible scenarios?

Klarman buys put options and credit-default swaps, which he calls “cheap insurance,” to protect Baupost against risks such as a steep fall in the stock market or a surge in inflation. He currently has a put, or an option to sell a set amount of a security by a specific date, that will pay off only if interest rates go dramatically higher, he said in his Boston speech. In an October 2008 letter to shareholders the firm said it benefited from credit-default swaps, without saying what the swaps were meant to protect against.

When Klarman can’t find investments he likes, he holds cash. “We prefer the risk of lost opportunity to that of lost capital,” he wrote in his 2004 yearend letter to shareholders. In 2007, Baupost gained more than 50 percent, even as it held more than 40 percent of its assets in cash.

Klarman Tops Griffin as Hedge-Fund Investors Hunt for `Margin of Safety’ (Bloomberg)

Using the cheap insurance strategy sounds really sensible to me. Fairfax took the same approach when they purchased credit default swaps to protect against the financial crisis and they paid off handsomely. For more ordinary investors, derivatives like CDSs are probably inaccessible.

There are still some ways of insuring against disaster. One would be using out the money puts on things like the S&P 500. This kind of approach makes it so you are betting on what are initially perceived to be improbable events. Klarman’s fund used this very approach in their early days, against frothy indices like the Nikkei. To learn more about this approach, be sure to read Michael Lewis’ awesome book The Big Short because sections dedicated to Cornwall Capital outline this style of investing.

There are downsides to this approach though. First, you will incur frictional costs whenever your hedges don’t work out. Second, they require you to identify the right kinds of things to hedge against. You end up having to pay attention to whether the market is overvalued or not. This should not be so hard if you are a disciplined investor because you’ll end up seeing your range of opportunities dry up. If you are the kind of investor that keeps making excuses to allow you to buy overvalued stocks, this strategy is not for you.

Seth Klarman and his fund continues to impress me with how they have taken Benjamin Graham’s ideals and adapted them to the modern world. It’s true, for most investors, some of his strategies are out of reach. But some of his ideals – like going to cash when things are overvalued, or taking a real bottoms up approach with your analysis and looking for catalysts in your investments are all things you can incorporate into your process right now.